An Approachable Dive into the Cash and Accrual Basis Accounting Methods
There are two methods of accounting: cash basis and accrual basis. Most bookkeepers and accountants are familiar with both. Surprisingly, many business owners are not.
At a high level, the two methods fundamentally vary in how they recognize revenue and expenses, impacting when transactions are recorded in financial statements.
Here’s an overview of each, what makes them different, and how organizations can best use both.
Cash Basis Accounting
In cash basis accounting, transactions are recorded only when cash actually changes hands. This method is straightforward and primarily used by small businesses and individuals because it closely mirrors actual cash flow. Key benefits include:
Recognition of Revenue and Expenses. Revenue is recorded when cash is received from customers and expenses are recorded when cash is paid out to suppliers or service providers.
Simplicity. Cash basis accounting is simpler to implement since it does not require tracking receivables or payables.
Cash basis accounting is somewhat limited though when it comes to financial insights. It may not accurately reflect a company's financial health or performance since revenue and expenses are not necessarily matched with the period in which they are earned or incurred.
Important to note: Most small business are “Cash Basis” tax payers.
Accrual Basis Accounting
Accrual basis accounting recognizes transactions when they occur, regardless of when cash actually moves. This method conforms more closely to Generally Accepted Accounting Principles (GAAP) and is used by larger businesses and corporations. Key benefits include:
Recognition of Revenue and Expenses. Revenue is recorded when it's earned, and expenses are recorded when they are incurred, regardless of when the actual cash is received or paid.
Matching Principle. Accrual basis accounting aligns revenue and expenses with the period in which they occur, providing a more accurate representation of financial performance.
Better Financial Reporting. Accrual basis accounting provides a clearer picture of a company's profitability and financial health over time.
Key Differences Between Cash and Accrual Basis Accounting
Timing. Cash basis accounting records transactions based on actual cash flows, while accrual records transactions when they happen, regardless of cash movements.
Generally Accepted Accounting Principles (GAAP) Compliance. Accrual basis is typically required for publicly traded companies because it adheres more closely to GAAP principles.
Small vs. Large Businesses. Small businesses often use cash basis for its simplicity, while larger businesses use accrual basis for better financial reporting and compliance.
Benefits of Accrual Basis Accounting
Companies who file taxes on a “cash basis” can also create financial reports on an accrual basis for management review. Accrual basis financial statements really hone in on profitability.
Here’s a quick rundown of what accrual basis accounting can fuel:
Better Matching of Revenue and Expenses. Remember, accrual basis accounting aligns revenue with the period it's earned and expenses with the period they're incurred. This provides a more accurate representation of the business's financial performance over time.
Improved Financial Reporting. Accrual basis accounting provides a better understanding of profitability, including a balance sheet that reflects assets, liabilities, and equity, and an income statement that shows revenues and expenses incurred during a specific period.
Informed Growth. Accrual basis accounting provides a more robust financial framework that can support growth. It offers better insights into financial trends, facilitates strategic planning, and helps in forecasting cash flow needs more accurately.
Better Management of Receivables and Payables. Accrual basis accounting requires tracking accounts receivable (income earned but not yet received) and accounts payable (expenses incurred but not yet paid). This helps in managing cash flow more effectively and ensures timely payments and collections.
Access to More Comprehensive Reports. With accrual basis accounting, businesses can generate more detailed reports, such as aged receivables and payables reports, which provide insights into outstanding debts and obligations. These reports are valuable for managing liquidity and negotiating terms with suppliers and customers.
Bottom Line
As mentioned, most small businesses file a tax return using “Cash Basis” reports. However, it is also possible to set up your accounting for both methods and use cash for taxes, accrual for profitability and financial health.
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